Taking a Stand on Banking

8/6/2019 Taking a Stand on Banking

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The author has chosen to use a question-answer format in order to make the often

complex subject matter, easier and more enjoyable to read. Q and A is not a dialoguebetween real people -- the author has provided the dialogue for both Q, standing for

Quaero, which is Latin means "I search for" and A, Auctor, which in Latin means

"person responsible."

Taking a Stand on Banking

Q: You realize of course that many people blame the costly savings and loan bailouts andthe increased number of bank failures on deregulation. There are currently calls forstricter controls and higher capital reserves. What's your stand on this issue?

A: My initial approach is the same in dealing with any public policy issue. Human naturemust be taken into account.

First, people are going to do what they want to do . They will find a way around the best

laid government obstacles.

Second, people act in their own self-interest and know better than an impersonalgovernment where those interest lie and how to attain them.

Third, a free market, based on the first two premises, functions more efficiently than abureaucracy.

Q: I think you have just advocated "more of the same"---laissez faire---what might beviewed by some as a prescription for disaster. The current weakness in the economy hasbeen traced to the weakness in the banking system.

A: And the weakness in the banking system may be traced to regulations which distortthe market and wreak economic havoc.

Q: I think the real question is whether regulators can protect taxpayers and promoteeconomic growth at the same time. Are they mutually exclusive goals? Will easy credithurt the banking industry?

A: According to congressman Charles Schumer of New York, the banking system isshell-shocked from too much lending, too many new ventures undertaken in the eighties.Now bankers are cautious and investing in U.S. treasuries for safety. Unfortunately

government securities are non-productive liquid type investments that will not providethe shot in the arm that the economy needs at the end of 1991.

Q: Why don't we start our discussion at the beginning with the earliest link betweengovernment and banking in this country? Didn't we have a central bank early in ourhistory?

A: You're right. In 1791 Congress created the first Bank of the United States.

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Q: What happened?

A: There was the time-honored heated debate involving states rights versus federal rightsand as a result when the charter came up for renewal at the end of twenty years it wasallowed to elapse. Congress tried again, forming the second Bank of the United States in

1816.

Q: And obviously that didn't last.

A: It was virtually destroyed with the election of its foe, Andrew Jackson, in 1832. Thebank had become extremely wealthy and Jackson feared the power its officers couldwield in influencing the government. He order his Secretary of the Treasury to withdrawall government funds and instead deposited the government's money in various statebanks, referred to as "pet banks". When the charter of the second Bank of the UnitedStates expired in 1836 it simply ceased to exist.

Q: So when did today's federally chartered banks come into existence?

A: Congress passed the National Bank Act in 1863 to help finance the Civil War. Thiswas the beginning of our dual banking system with some banks chartered and protectedand regulated by the federal government and others by the state.

Q: You know, the Japanese established the Ministry of Finance, their version of ourFederal Reserve system, in 1882.

A: That was long before we established our own Federal Reserve System in 1913.Actually the modern structure of our banking system began in 1927 with the passage of

the McFadden Act.

Q: I've never heard of the McFadden Act.

A: It denied nationally chartered banks the right to operate branches within a state unlessthe already existing state chartered banks were given equal rights. The McFadden Actoriginally permitted national banks to exercise securities powers. It wasn't until 1933 withthe passage of the Glass-Steagall Act that banks and savings and loans were forbidden tounderwrite securities.

Q: This was New Deal legislation instituted under Franklin Roosevelt. Right?

A: Right. It was an attempt to insulate the various types of banks from competition bycommercial enterprises and also to protect consumers from having their deposits used bybanks speculating in the stock market.

Q: I guess the crash of 1929 was a fresh and scary memory in 1933.

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A: Absolutely. 5,500 banks failed in the 1920s. In just the three years 1926-1929, 125banks failed in Florida alone, as a result of insider abuses and conscious conspiracies todefraud. The officers of the Palm Beach National Bank should have been indicted in thesummer of 1926 for embezzlement and criminal fraud, according to the bank's receiver,but instead an official political statement was issued claiming the bank failed because of

the local economy and unforeseen disasters which hit agriculture and industry in SouthFlorida.

Q: A cover up!

A: The officers of a defunct state bank were indicted for making illegal loans by a grandjury in Palm Beach County a few months later.

Q: I bet that was small comfort to depositors who lost their savings.

A:Now it is taxpayers rather than depositors who pay for the excesses and abuses of

management.

Q: You mean because ultimately taxpayers stand behind the government-guaranteeddeposits?

A: Exactly. Let me backtrack to 1913 to the establishment of the Federal Reserve Bankwhich was supposed to ensure the soundness of the banking system.

Q: The number of bank closures during the Great Depression bears testimony to the factthat it didn't do its job.

A: You should know by now that when one agency fails to do its job, the usualgovernment solution is to add another agency and so we got the Federal DepositoryInsurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation(FSLIC).

But just like any safety-net, deposit insurance, introduced in the 1933 Glass-Steagall Act,has encouraged risk and poor management. It has distorted the system.

Q: What do you mean?

A: Originally the Federal Depository Insurance Corporation (FDIC) was supposed to stop

runs on banks, but instead it has effectively stopped depositors from keeping an eye ontheir savings, and bankers from being prudent.

Q: Best selling author and former banker Paul Erdman, on March 5, 1987, told hisCommonwealth Club audience that

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Every money center bank in the U.S. gets over half its deposits from abroad...theconsensus of the Wall Street types is that it (i.e. run on U.S. banks) has a 25percent chance of occurring.

But no big deal, he said, even if runs occur--the world's money has no better place to go!

A: FDIC insurance now covers any deposit up to $100,000. As long as a deposit remainsunder that $100,000 level it is the responsibility of Uncle Sam to monitor bank judgment.

Q: How many people do you know with $100,000 sitting in the bank?

A: You've got a point. But it's worse than you think. Currently an individual or group canbe insured beyond the $100,000 limit just by opening another account once the $100,000insurance limit is reached in one bank. A recent reform limited the number of insuredaccounts to two in any one bank.

Q: Some reform! The customer could go across the street to open up accounts three andfour!

A: Well I know if the Bush administration were to have its way, large pension funddeposits would no longer be insured on the pass-through theory.

Q: What in the world is thepass-through theory?

A: The theory that says that entities like pension funds, should be considered as so manyindividual deposits, each below the $100,000 ceiling deposits. The fact that they arelumped together should be overlooked for insurance purposes.

Q: Maybe it's time something was done towards gearing bank premiums to risk andperhaps even trimming the guarantee from $100,000 to a modest sum more in keepingwith the average mans savings, since he is the one who gets tapped if a bailout is needed.And how about prohibiting one person from having several insured accounts totaling over$100,000?

A: Why not? Pay outs could be lessened by reducing the dollar amount of depositscovered below $100,000 and limiting the pay outs to a per person liability rather than peraccount. That was supposed to have been done in 1984 when the FDIC and the FederalHome Loan Bank Board supposedly banned new brokered accounts.

Q:Brokered accounts? Is that what they call the really large deposits which are split into$100,000 accounts split to take advantage of FDIC insurance limited to that amount?

A: You've got it!

Another idea is to balance the FDIC's income-outgo ratio by co-insurance.

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Q: You mean requiring the depositor to pick up at least some of the tab for insuring hisown particular account?

A: Absolutely. In fact why not do away with the FDIC and go back to caveat emptor.

Q: In other words, why not let individual depositors shop for their own depositinsurance?

A: Opponents claim banks would be open to runs, something deposit insurance wassupposed to alleviate. Besides, private insurers couldn't begin to assume a $4 trillionliability.

Q: Then why not categorize banks? There could be "safe banks" where deposits areinvested in government and agency securities, and home mortgages. These banks couldbe covered by the FDIC---backed ultimately by taxpayers. "Risky banks" would havemore investment latitude but depositors would not be provided with insurance. Of course

they could obtain their own.

A: Dream on! Insurance for depositors of a risky bank would be sky high. But I see twoother problems:

First, most consumers would prefer the risky banks because of the higher possiblereturns. Americans are optimists! According to Lowell Bryan, author of Bankrupt:Restoring the Health and Profitability Of Our Banking System, most institutionalinvestment, a total of one billion in deposits and other borrowed funds, would leave theinsured safe banks.

Secondly, the investments that makesafe banks safe, like Treasury bills and so forth, arealready backed by taxpayer guaranties, making FDIC protection redundant.

Q: From what I read, Lowell Bryan would favor categorizing the banking business. Heeven refers to core banks, federally insured and in the business of taking deposits andlending to small enterprises. He envisions only ten to twenty of these banks formed viamergers of what are now the 120 largest bank holding companies who have two-thirds ofthe country's deposits.

My facts differ from yours. In a review of Mr. Bryan's book [Business Week8-5-9]) itwas said that:

Of the $2.6 trillion now in bank deposits, Bryan calculates, about $600 billionmight leave core banks for higher yields offered elsewhere.

More risky business would go to money-market investment banks and financecompanies which would primarily make loans to real estate investors.

A: What can I say? Co-insurance is something to play with though.

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Q: I like the idea of co-insurance too. There are almost unlimited possibilities for fundinginsurance by combining, in one way or another, resources of the government, the bankingindustry and of individual depositors.

Q: Where does FDIC get its money now?

A: Banks pay premiums into the Bankers' Insurance Fund (BIF). These premiumsexceeded disbursements leaving as much as $18.3 billion in the fund as recently as 1987.But by the end of 1991 the insurance fund had dropped pretty near to zero because of theincreased number of pay outs.

Q: You mean pay-out caught up to premiums?

A: Exceeded premiums, because of the large number of bank failures.

Q: So you're saying by 1992 the insurance fund will be insolvent?

A:Not so much insolvent, as illiquid.

Q: What's the difference?

A: Insolvency is a permanent inability to meet obligations whereas illiquidity signifies atemporary but rectifiable shortfall. The BIF, which is part of the FDIC and because morepeople are familiar with the FDIC I will simply use that term for ease of discussion, stillhas a source of income and good long-term prospects of solvency. It's just that its incomeis spread out over a long time period and the need for disbursement is concentrated andimmediate because of the unprecedented bank failures.

Q: So what's the solution?

A: Adding capital to a reformed system.

A: Yes, adding capital to a reformed system.

Q: Oh, is that all?

A: Let's take it a step at a time. As we said, we can give the FDIC an infusion of capital by borrowing, either from the banking industry, the Federal Reserve Board (Fed) or

taxpayers. Which will it be?

Q: I have a sneaky feeling that this is one of those questions where no matter the answer;it's going to come down on the taxpayers.

A: Let's eliminate the Fed as a potential saviour because of the precedent any bailout ofthe banking industry by that independent agency would set. There are plenty of otheragencies that would soon press the Fed to advance funds to them.

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Q: But I thought the Fed was expressly set up to insure the stability of the nation'sfinancial and banking system. Having the Fed ride to the rescue seems to be a legitimateand practical solution.

A: You're right that the Fed can, should, and has inserted funds into the system in

emergency situations to insure stability, but we're talking here about long termrecapitalization of an insurance fund. Let's examine the other alternatives.

Congress has recently [fall of 1991] been working out the fine points on legislation thatwould have the Treasury loan seventy billion to recapitalize the FDIC.

Q: The U.S. Treasury? Just as I thought; that's in reality a taxpayer bailout just like theSavings and loan bailout.

A:Not "just like".

Q: Oh sure, the banks will pay back the loan out of premiumsmaybe even largerpremiums due to higher assessments, but remember the savings and loans were supposedto pay back taxpayers (the Treasury) out of the sale of foreclosed assets.

A: That's different. Those assets were mostly real estate. Due to changes in the tax codeand the economy, real estate values have fallen and the cost to foreclose and managethem has gone through the roof.

Q:Not to mention the regulations and restrictions which have hamstrung the liquidationprocess.

A: There's no doubt that the delays have been extremely expensive. But you must admitthat the source of loan repayment by the banks is more easily identified than the source ofthe S & L loan repayment.

Q: You mean the banking industry reimburses the Treasury via premiums charged tomember banks whereas thrifts are forced to depend on the proceeds from asset sales---mainly real estate.

A: Exactly right. Premiums receivable can be calculated, whereas the net income fromproperty sales is inscrutable.

Q: But what is not known is the cost of an undetermined number of bank failures. Thatcost will ultimately determine the net premiums available to service any Treasury loan tothe FDIC.

A: That's why the solution is more than recapitalization. Reforms are needed to reducethe number of bank failures.

Q: Reforms such as?

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A: That is the debate that is going on. Some experts favor measures to restrict the rangeof bank activities, linking deposit insurance premiums with individual bank risk, raisingthe capital requirements of banks and more frequent examinations of bank records andmanagement.

Q: I suppose which activities and the degree of restriction would be left to falliblelegislators and regulators, many with little expertise in financial fields. This does notsound like something you would favor.

A: You're right. Aside from my philosophical abhorrence, I see giant pitfalls and wouldprefer that the marketplace determine the kind and degree of restrictions. If regulators aretoo restrictive they could cause, rather than prevent, bank failures.

Q: Don't forget the cost entailed in requiring more frequent examinations and highercapital reserves.

A: Bank managers will have greater incentive to act prudently once they have morecapital on the line and this, by itself, should reduce the probability of bank failures.

Q: What about tapping the reserves of the banking industry?

A: That's on the agenda. For instance, I can't figure out why foreign deposits are by-passed when calculating the premiums banks must pay into the Bank Insurance Fund.

Q: You mean foreign deposits aren't insured now?

A: They're insured if the bank fails but they are not counted when determining the size of

a bank's premium. They get a free ride.

Q: I would think that would make foreign funds a preferred source of capital for banks!

A: You're right. This is a regulatory induced bias.

Q: I've got another idea. In his 1991 book, The S&L Debacle, Professor Lawrence Whitesuggested,

All banks would be required to buy amounts of "preferred stock" in the FDICequal to one percent of their domestic deposits, and they could carry this stock at

par on their balance sheets.

This way the FDIC would get an infusion of approximately $25 billion and bankswould receive dividends on their investments. Since they could carry the preferredstock on their balance sheets as an asset, the banks net worth for accountingpurposes---assets minus liabilities--would not go down.

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A: Excuse me. Wouldn't that amount to double-counting? I can't see letting the FDICinclude the twenty-five billion banking contribution in its resources while also allowingthe banks to carry the par value of the twenty-five billion preferred stock on its books.

Q: OK. How about if the preferred stock is publicly held and traded just between banks,

and the preferred stock is carried on bank balance sheets at current market values asreflected by that trading?

A: I don't think it is possible to strengthen the FDIC via banks funds, without weakeningthe banks.

Q: If I'm right, banks place their capital reserves with the Federal Reserve Bank whichgets away without paying any interest on those reserves. Why not make the Fed payinterest?

A: Sounds good on the surface, but remember the Fed pays any excess funds into the

Treasury, so any interest paid by it would ultimately reduce the Treasury's income andjust be one more hit on the taxpayer.

Another suggestion is to lower the legal lending limit of federally insured institutions.

Q: What are the lending limits now?

A: Most banks can lend somewhere between ten percent and twenty percent of theirequity to a single borrower.

Q: Based on the safety in diversity maxim, I suppose.

A: Correct. If banks were held to lower limitssay two percent to five percent, theywould be forced to diversify even more and their lending capacity would be spread morethinly over a broader spectrum.

Q: Wouldn't that hurt the large borrowers?

A: I'm surprised at your concern. Large borrowers generally have many sources of funds.Small and medium size borrowers have fewer alternatives and this policy would actuallyfree up funds for them.

Q: So you would favor this regulation?

A: You're trying to catch me in the inconsistency of favoring regulation. Let me put itthis way. If there has to be regulation, then limiting individual bank's exposure to largespeculators and opening up capital sources for a greater variety of more modestendeavors, is one of the better regulations.

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Q: I've heard it said that if insured banks had the same loss rates that they enjoyed priorto 1980 that they would have suffered only nine billion in bank loan losses in 1990instead of $29 billion actually recorded. Is this true?

A: Perhaps there is a clue in the fact that only one Canadian bank failed during the 1920s

and 30s. Bert Ely, who has written a book for the Cato Institute which details the bankingcollapse in America in the early 1930s, attributes the relatively smooth sailing that took place over the same time period in Canada to the fact that ten banks operated fourthousand branches throughout Canada. This gave Canada's banks a broad geographicaldispersion for their banking risks.

The independent bank, far from being the strength of small town America was its greatestweakness according to Mr. Ely. He believes the banking collapse in America in the early1930s was caused, at least in part, by the restrictions on branch-banking which kept U.S.banks unnaturally small.

In 1930 there were 23,700 banks and only three percent of them had any branches at all.In the early thirties the typical bank failure could be traced to fraud or a local economicdisaster.

Q: Interesting.

A: Of the 4,800 bank failures during the Great Depression era, most banks were too smallto carry on investment-banking activities and therefore there was really no justification,Mr. Ely points out, for enactment of the 1933 Glass-Steagall Act.

Q: That's the law mandating separation of commercial from investment banking. Are

other countries having banking problems or is this unique to the United States in the1990s?

A: Bank regulators from around the world met in Amsterdam at the end of 1986 andexpressed their concern about the dangerous banking practices which they feared mighthave the potential to touch off a global banking crisis.

According to L. William Seidman, Chairman of the Federal Depository InsuranceCorporation (FDIC), bank failures increased from 49 in 1983 to 138 in 1986; 80 percenttaken over by healthy banks and 20 percent liquidated. A report issued by the HouseGovernment Operations Committee in Washington DC, claimed of all the banks that

failed between January 1980 and June 1983, 61 percent were involved in actual orprobable criminal conduct.

Q:Probable criminal conduct? That means a prosecution and sometimes a trial must take place in order to determine if the conduct was criminal. I'd also like to point out that1,700 new banks were founded between 1981 and 1985.

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A: Many experts believe the nations banking system is resting on quicksand. There is ascary scenario that must be considered: the collapse of one large bank could lead to thefailure of many more interconnected banks; business credit would then be constricted andsurviving banks would be unable to purchase the bonds that major corporations dependon to finance their operations and expansions. It is possible that as desperate bankers try

to stave off collapse, loans would be called, causing defaults and bankruptcies throughoutthe economy.

Q: Not a pretty scene to contemplate. Listening to the dangers, one wonders how ourbanking system has survived as long as it has.

A: The fact that it has survived should tell you something about the scare mongers.Between 1865 and 1933, before the government insured deposits, depositor-lossesaveraged only 0.78% of the total deposits in all commercial banks.

Q: Before the FDIC? I thought there were all kinds of bank runs.

A: In a study published by MIT Press in 1986, titled Perspectives on Safe and SoundBanking: Past, Present and Future, it was argued that costs imposed by bank failures andassociated runs, were no greater than costs imposed by the failure of non-banking firms.Runs were examples of depositor discipline that shut down poorly managed and insolventinstitutions.

Q: You mean the market at work.

A: I guess you might say that. But even though these losses were small, they neverthelessexceeded the losses of the FDIC between 1988 and 1989. According to the report, FDIC

losses were approximately 0.25 percent of total bank deposits at insured banks or roughlyone-third of the depositor losses experienced during the crisis years prior to depositinsurance.

Q: If insurance cut the loss rate by two-thirds, you don't think anybody is going to wantto do away with it do you? Besides, bank panics are contagious.

A: The study showed that only two or three episodes before 1930 suggested anycontagion as indicated by substantial increases in nationwide currency-deposit ratios andabsolute declines in bank deposits. These researchers argue that the U.S. banking systemwas fundamentally sound prior to federal deposit insurance and was not prone to

destabilizing banking panics. That was said by Jonathan Neuberger, Economist for theFederal Reserve Board of San Francisco on April 21, 1991. He also said, researchsuggests that banking markets are fundamentally stable and not prone to contagiousruns."

Q: What did currency have to do with it?

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A: In the early 1930s, frightened depositors irrationally converted their bank accountsinto currency. U.S. currency is still the most widely used medium of exchange. Todaythere is more than $250 billion worth of currency in circulation and those who hold itdon't have to worry about risk of default.

Q: They do have to worry about theft or losing it. Credit cards and checking accounts aremuch more convenient and favored, I'm sure, by most people.

A: In their 1963 study of monetary history, economists Milton Friedman and AnnaSchwartz claimed that the monetary contraction of the thirties intensified the economicdepression. They blamed the Fed for failing to pour reserves into the banking system.

Q: I would imagine the lack of funds, led to the bank runs which in turn produced acredit crunch which acted as an additional drag on the economy. A domino effectright?

A: That's one theory. In 1987 the FDIC insured 14,822 institutions with over two trillion

in deposits, and for the first time since its founding, FDIC reserves of slightly more thaneighteen billion were in danger of running out. The Federal Savings & Loan InsuranceCorporation (FSLIC) which then insured thirty-two hundred Savings and Loancompanies, was technically bankrupt as 1987 began.

Q: Experts tell us that reforming the deposit insurance system is necessary for the healthand long term profitability of the banking system. But I want to know how this is going tobe done?

A: Interstate banking and branch reform would help. Cost savings from mergers has beenestimated at ten billion in pre-tax savings. Remember the industry earned only $24.5

billion before taxes in 1990less than an eight percent return on equity overall.Consolidation and interstate branching would help banks raise the capital they need. Overa five year period, the capital created from these savings could support more than $600billion in new lending.

Q: This is the way I see it: When OPEC money came pouring into this country in the lateseventies it had to be recycled and the bankers decided that a lending spree to the ThirdWorld countries would do the trick. At the end of 1982 the nine largest U.S. banks hadlent 146 percent of total capital, reserves, equity and subordinated debt, to LatinAmerican borrowers. Not surprisingly, by the end of 1986 the list of problem bankstotaled 1,484. Since not all banks acted irresponsibly, it only makes sense to determine

capital requirements and insurance premiums according to the actual risks assumed byindividual banks.

A: The catch is not all risks are known or knowable.

Q: But if they could be identified you can see how capital requirements at the higher-riskbanks would encourage those banks to be more careful. Right?

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A:Ifis a tiny word but a powerful obstacle. This is not a simple problem. Off-balance-sheet items are involved and then there's the interdependency of foreign banks, manyunregulated, with U.S. regulated ones. To tell you the truth, I'd rather save a discussion ofour interaction with foreign banks until a little later, if you don't mind.

Q: OK. I'll backtrack. We talked about the FDICbank insurer. Would the samediscussion apply essentially to the FSLICthe insurer of the savings and loan industry?

A: Essentially. Since its beginnings in 1933, the FSLIC had supported itself withpremiums from institutions it insured and with income from investments. Even though ithad the authority to borrow up to $750 million from the Treasury, it never needed to doso before 1987.

Q: That sounds like the taxpayers would be left holding the bag if the losses resulted inthe institution's collapse.

A: It is this open-ended liability with no limits to future costs which needs to bereconsidered.

Q: Who had oversight? Any institution besides Congress?

A: The FSLIC was controlled by the Federal Home Loan Bank Board which admittedthat $6 million a day was going down the drain because of the sick institutions it waskeeping alive in early 1987.

Q: Why in the world was it keeping sick institutions alive?

A: The 99th Congress was unable to pass legislation which would have pumped fifteen billion into the ailing FSLIC and would also have permitted regulators to sell failinginstitutions. Opponents argued that additional legislation wasn't necessary since manystate laws already allow such sales. On top of that, the U.S. League of SavingsInstitutions incorrectly estimated the FSLIC would have $17.42 billion to cover pay outsover a five year period.

Q: But if I remember correctly, the money requested was in the neighborhood of $25billion.

A: Right. Legislation to raise that amount over a five year period was put before the

100th Congress. Under the Treasurys plan the Federal Home Loan Banks would havesold debt, backed by zero-coupon bonds, for about fifteen billion over a five year periodwith an additional ten billion to come from income from other investments and specialassessments on federally insured thrifts.

What Congress actually passed in the summer of 1987 was considerably less ambitious.The banking-reform bill provided a $10.8 billion industry-financed package for the ailingFederal Savings and Loan Insurance Corporation, banned the creation of any more

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limited-service banks and prohibited banks from entering any securities businesses untilMarch, 1988.

Q: Why didn't they just combine the two insurersFDIC with FSLIC?

A: Some people did suggest that merging the FSLIC with the FDIC would, back in 1987,have provided nearly twenty-nine billion to handle bank and savings and loan failuresover the next five years without dipping into the corpus of the FDIC fund. Former headof the FDIC, William Issac, was not one of them, nor was his successor, WilliamSeidman. Both men were against a merger.

Q: How did bankers and savings and loan officers feel about a merger?

A: Of course there were a variety of individual opinions but in general the commercialbanks were afraid a merger might mean an increase in their deposit insurance premiumsand would amount to the bankers' bailing out the thrifts. The savings and loans were not

exactly overjoyed, fearing a merger might mean their ultimate extinction, or at leaststricter controls.

Q: That's chutzpah! It's not as if they were doing such a great job regulating themselves.

A: I read in the August 1983 copy ofCalifornia Lawyerthat loopholes were tightened soit was harder for non-banking companies to acquire banks and run them as strictlyconsumer-banking organizations. In December 1983, non-banks were brought under the jurisdiction of the SEC by attempts to broaden the definition of lending to include thepurchase of commercial paper, and the definition of deposits to include NOW accounts.

Q: I remember some people questioned the idea that purchasing certificates of depositshould be equivalent to making a loan.

A: In 1984, despite protests from the Florida Bankers Association, the Fed gave UnitedStates Trust Co. of New York, the go-ahead to convert a state-chartered trust company toa nationally chartered consumer bank. This was a first.

Q: Why did the Florida group object?

A: They felt the Fed's action violated the section of the Bank Holding Company Actwhich prohibits banks from owning non-banking entities. They exaggerated a bit and

suggested that a local car wash or local bordello could now own a bank.

Q: I've never heard of the Bank Holding Company Act?

A: The Bank Holding Company Act of 1956 forbade holding companies owning morethan one bank from operating in various states without express approval from the statesthemselves. In 1970 even one-bank holding companies were brought under thejurisdiction of the Federal Reserve Board. These regulations were a response to the rapid

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expansion of financial conglomerates, mostly based in New York. Legislation waspushed by members of congress from states such as Texas and Illinois where state banksweren't even allowed to open branch offices intrastate.

Q: I remember when Bank of America was the largest bank in the world.

A: In 1970 the ten largest banks in the world in terms of assets, were American. Nownone are.

Q: What do you think about the merger of BankAmerica and Security Pacific, two ofCalifornia's largest banks, which took place in August 1991?

A: For one thing it shows the pressure banks are under to expand in order to cut costs andcounter the bad loans accumulated over the years. Expansion is their ticket to competitionwith the larger foreign banks.

Q: Does that mean BankAmerica is now the largest bank, at least in this country?

A: In terms of branches, 2,400 and ATMs, 4,000 you're right. But even with the merger,its assets are $190 billion versus almost $217 billion at New York based Citicorp. Butalthough Citicorp has more assets than BankAmerica, BankAmerica is ahead in profitsand is controlling its expenses The BankAmerica-Security Pacific merger is supposed tosave about $1 billion in annual operating costs over a five year period. Besides, Bank ofAmerica has more equity capital than Citicorp.

Q: And with its equity capital it can expand beyond the ten states in which it presentlyoperates.

A: Not only can, BankAmerica's CEO, Richard Rosenberg intends to expand hisoperation. In fact earlier in 1991 he was foiled in his attempt to purchase the Bank of New England (acquired by Fleet/Norstar Financial Group) which was especiallyattractive to Mr. Rosenberg who is himself a native of the Boston area.

Q: Surprisingly it wasn't that long ago [1986] that Bank of America was itself almostswallowed by First Interstate bank.

A: Just to show how life is unpredictable, on August 16, 1991 Richard Rosenbergaddressed the San Francisco-based Commonwealth Club. This was only a few days after

his bank's merger with Security Pacific.

Q: Isn't Security Pacific the bank that sold some of its consumer and commercial servicegroups to Japan's Mitsui Bank in the summer of 1989?

A: You're right. Mitsui reportedly paid Security Pacific $100 million for a five percentshare, valuing the financial services businesses at fifteen times operating earnings.

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Q: That's unbelievably high. I suppose that's because banking analysts preferred regionalbanks like Security Pacific to money-center banks like BankAmerica and Citicorp.

A: Possibly, and perhaps with good reason. Money-center banks were involved with badloans to LDCslesser developed countriesan issue that was newsworthy and

damaging a few years ago. In fact in the summer of 1989 federal regulators required awrite down of some of those LDC loans which made the regional banks like SecurityPacific, look good in comparison.

Q: But that was then and this is now.

A: That's astute! Mr. Rosenberg talked about the overcapacity of the American bankingindustry and predicted more mergers in the future between the larger banks. He pointedto his own just completed merger and to the Chemical Bank and Manufacturers Hanovermerger which had taken place in July 1991 as examples.

Q: Did he think mergers were a good sign?

A: Yes, in as much as he saw overcapacity, along with restrictive legislation, assignificant contributors to the competitive disadvantage American banks have beensuffering in the global market.

Q: If I recall, Richard Rosenberg took over the retail division at BankAmerica back in1987?

A: That's right. He had been the President of Seafirst in the state of Washington. He hadturned down the BankAmerica job twice before.

Q: He apparently has a reputation as a great marketer.

A: Absolutely. He encouraged customers to use services beyond checking and savingsaccountssafe deposit boxes, IRAs, CDs, credit cardswhich all earn separate profits.

Q: Many experts think Mr. Rosenberg was primarily responsible for turning aroundBankAmerica's fortunes.

A: As you said, he is a great marketer. He used gimmicks such as giving away threeyears of free checking accounts to anyone who walked in the door of any Bank of

America branch on a certain day, or if a new checking account was opened before acertain date the customer received coupons worth up to $1,200 at American Airlines,Hertz, Hilton and Carnival Cruises.

Q: Aggressive marketing of banking products may be the key to the future success ofbanks.

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A: It's here today. Already consumers use banks not only as a place to deposit theirmoney or for the convenience of checking accounts, but they purchase certificates ofdeposit, have payroll checks direct-deposited and can get cash through interbank ATMnetworks

Q: You forgot to mention loans. Credit cards often make it possible to draw loans from avariety of institutions across the country. With a little work, consumers can findcompetitive rates.

A:Not only that, competition has meant more convenience for consumers. Many banksnow stay open forty-five hours a week instead of twenty-seven as was the norm just acouple years ago. Some are even open Saturday and a few hours on Sunday and othersoffer twenty-four hour phone information.

Q: These services must be costly to provide.

A: The costs are passed on to consumers who don't seem to mind as long as volumeallows the banks to keep individual charges low.

Q: The something for everybody principle. I understand that BankAmerica serves overfive million households and has been earning over a billion dollars a year.

A: That's right. It is reportedly the most profitable bank in the nation. In 1990 itpurchased banks in Oregon, Arizona and New Mexico and now owns the largest in bankin California, Bank of America, and in Washington, Seafirst.

Q: I heard that between 1987-1990 its consumer lending more than doubled from

nineteen billion to thirty-nine billion.

A: I know; it's amazing. Mr. Rosenberg had the thirty-one bank districts in Californiahold recognition dinners and sales rallies. The morale was high to the extent that eachbranch office had its own colors and unique branch cheers.

Q: Sounds like high school sports or Amway sales rallies.

A: The bank instituted incentive pay and recruited many of their current top managementpersonnel from Wells Fargo bank. They managed to pare problem loans from five billionto three billion over only three years.

Q: Is it true that most California banks pay less on consumer deposits than competitorspay in other states?

A: I guess it is. In 1990 BankAmerica paid consumers only 6.7 percentthe consumersthen paid the bank eighteen percent on credit cards and ten percent plus to borrow on theequity on their homes. Meanwhile Citicorp in New York paid eight percent. That saved

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BankAmerica seven hundred million and accounted for half its pretax profits. As we saidat the beginning, consumer banking can be very profitable.

Q: Not to mention the loss carry-forwards the bank had from its years of enormouslosses.

A: But these tax breaks, which are said to have added two hundred and forty million to1990 net income, disappear in 1991. This, plus the recession may mean 1991 is a learneryear.

Q: I heard something about BankAmerica buying at least a dozen failed savings andloans from the Resolution Trust Corporation. [RTC is the government agency set up in1989 to dispose of the assets foreclosed during the S & L fiasco of the late 1980s.]

A: That may be. If you are worried about the possibility of a future monopoly, rememberthe numerous new nonbank companies.

Q: It's hard to determine what institution is and is not a bank now days.

A: It's interesting to see how that came about. Congress had defined a bank as aninstitution that accepts demand deposits and makes commercial loans. In a 1980 case,Gulf & Western Corporation substituted personal loans for commercial loans and viola,the first consumer bank was recognized.

Q: Some people say we have too many banks for our population in this country anyway.Do you agree?

A: I'd like to see the market place take care of that possibility. Mr. Rosenberg pointed outthat American consumers are served by 12,600 commercial banks, 2,000 savings andloans and 16,000 credit unions. For instance Canada has 65 commercial banks, Japan hasless than 150 commercial banks for a population of about 120 million people and Europe,with a population close to 320 million has about 3,000 commercial, savings and mutual banking companies. Our own commercial banks have been slowed while theircompetitors have been allowed to race around the course without any such handicap.

Big Firms like General Electric, General Motors, Sears; none of them, or others like themthat offer bank or bank-like products and services has to adhere to bank regulations ormeet capital standards that banks must meet, or hold reserves at the Federal Reserve

Bank, or most importantly, meet stringent Community Reinvestment Act requirementsthis despite the fact that these competitors are extending credit in direct competition withthe banks.

Q: It's my understanding that bank charters have been readily granted in the USA anduntil the late 1980s foreign banks were able to open branches anywhere in the countryeven though domestic banks were prohibited from doing the same thing in Japan.Correct?

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A: Japan doesn't allow foreign banks to develop money market instruments or managemutual or pension funds in its country. The Japanese Ministry of Finance keeps interestrates low and gives Japanese banks their lower cost of capital. David Mulford, UnderSecretary of the Treasury for International Affairs, said in early 1990, Basicderegulation, sweeping change or bold challenges to the way the existing system benefits

traditional Japanese financial institutions are hard to find. Full deregulation is what isneeded The failure by Japan to provide full access to its markets is particularly serious,given Japan's current financial and economic position in the world.

Q: That doesn't seem fair.

A: It gets worse. American laws allow foreign competitors to engage in the mostprofitable lines of banking business without carrying the same cost burdens of Americanbanks. On top of this, our own commercial banks end up paying premiums that insure the brokered deposits of investment banks that cater to generally the most sophisticatedfinancial consumers.

Q: In addition to the expenses and costly regulations imposed on domestic lenders,foreign lenders have access to cheaper overseas funds.

A: Exactly so. These foreign entities can therefore offer better interest. Is it any wonderthey cornered thirty percent of the loans made to American business in 1991?

There's no doubt American banking regulations benefit foreign competition. Thanks tothe International Banking Act of 1978, approximately fifteen large foreign banks wereexempted from the provision in the 1933 Glass-Steagall Act which prevents Americancommercial banks from underwriting corporate debt or equity offerings in the United

States.

This unfair advantage has contributed to todays situation where only one U.S. bank,Citicorp, can be found in the ranks of the ten banks with the most assets in the world.Last year a subsidiary of the Union Bank of Switzerland managed debt issues for Borg-Warner Acceptance Corporation, Transamerica Financial Corporation and AlliedSignalall in New York. Many foreign banks have been on a spree, buying shares inAmerican investment banking establishments.

Q: That's right. Not long ago Sumitomo Bank of Japan purchased a five hundred milliondollars share in Goldman Sachs, one of Wall Streets more prestigious firms in order to

break into investment banking in this country.

A: To counter the ridiculous situation that allows foreigners to own banks in more thanone state while making it illegal for a domestic bank to do so, in 1987 twenty statesadopted reciprocal privileges.

Q:Reciprocal privileges? What do you mean?

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A: Certain states allowed citizens of other states to own banks within its borders as longas the privilege was reciprocated.

Q: Alan Greenspan, Fed chairman, said in April, 1990, There is reason to believe thatthe opportunity for a bank to diversify the products or services it offers or to diversify

geographically may in some cases raise its rate of return and lower its risk.

A: Well you can see something is being done about geographical diversity.

Q: When are we going to do something about product diversification?

A: Congress has been urged to pass legislation that would overhaul the Glass-SteagallAct and permit banks to engage in underwriting of commercial paper, mortgage-backedsecurities, revenue bonds and mutual funds.

I remember when now retired Senator William Proxmire, was chairman of the Senate

Banking Committee, he wanted to dismantle all or part of the Glass-Steagall Act. He sawit as a legacy he wanted to leave the country.

Q: Why not allow capital-rich companies to affiliate and add their capital base toindividual banks?

A: It's the same old territorial scenario. Those that have a good thing going are neveranxious for competition.

David Silver, President of the Investment Company Institute, in his article for the April1987 edition of the Financial Planning News, expressed a fear that Congress might be

getting ready to repeat what he referred to as the disastrous 1927 McFadden Act. Mr.Silver suggested to readers that with recent sob stories about bank failures and theinability to compete, the same sensitivities are being appealed to that originally openedthe way for the McFadden Act.

Q: I can see where Mr. Silvers might prefer to not have the competition of federallycharter banks.

A: I wonder if there is such a thing as an unbiased viewpoint. We cannot escape ourbackgrounds and we shouldn't deny our legitimate interests.

Q: Anyway I thought some commercial banks were already dealing in securities.

A: Although commercial banks have been allowed to underwrite government guaranteedmortgage-backed securities, such as Ginnie Maes, they haven't been able to touch CMOs,as far as I know.

Q: What's a CMO?

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A: Sorry. CMO stands for collateralized mortgage obligations. CMOs are bond-likesecurities backed by a pool of mortgages whose cash flows are repackaged to obtainsecurities of mixed maturities. CMOs allow investors and underwriters some protectionagainst prepayments by mortgage holders. If Congress wont let them compete morefreely, some banks may simply give up their banking charters so they will be free to

diversify into other businesses.

Q: Many of the nations largest banks have applied for an expanded role in theunderwriting of securities.

A: Underwriting involves purchasing securities in a block from the issuing corporationsand selling them in smaller denominations to a variety of investors.

In contrast to Mr. Silver, Federal Reserve Chairman Alan Greenspan believescommercial banks need more latitude in order to compete against freewheeling foreigninstitutions and Wall Street firms and therefore hopes Congress will overhaul Glass-

Steagall.

Q: I've just got to tell you about a piece I read last summer in the August 26, 1991 editionof the Wall Street Journal. It was an article by Alan Murray in which he discussed theantiquated way we handle Treasury auctions in this country. Did you see it by anychance?

A: If I did, I don't recall it.

Q: According to Mr. Murray, the government securities market has always put the dealerabove the customer. In the past Treasury has entertained fears that it might hold an

auction and no one would show up. It was soothing to know the dealers at least, wouldbid in every auction.

A: You mean someone at the Treasury Department is actually afraid the U. S.government might offer securities for sale and there would be no takers? Give me abreak!

Q: That was Mr. Murray's point. Such assurances are absolutely unnecessary in this ageof instant global communication. He agreed there is no possibility that the U.S.government would be unable to sell its debt and therefore why do we need and pay forthe expensive services of the forty primary dealersa n outdated luxury that should be

phased out. He suggests we examine ways to improve the efficiency of the market,reduce the cost of financing the government's huge deficit so the taxpayer can have somerelief.

A: I think I might have read the article, now that you mention it. Didn't it have somethingto do with the Salomon Brothers scandal?

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Q: That incident was supposed to be the catalyst for a rethinking of the auction systemcontrolled by the forty licensed primary dealers.

A: Actually anyone can place competitive bids, but the bidding process is so cumbersomethat few outsiders do it. The common bidders and large mutual and pension funds, route

their bids through the primary dealers. This gives these forty dealers valuable informationabout how the large institutions are going to bid and is in itself a temptation to abuse,according to Mr. Murray. We take time to fume about underwriting by banks and ignorethe manner in which over two trillion worth of government securities is auctioned everyyear.

Q: Let me see if I've got this right. The Glass-Stegall Act prohibits banks from beingprincipally engagedin underwriting ineligible securities.

A: Right. But to show that they are notprincipally engagedbanks have proposed ceilingsto demonstrate that underwriting in no way makes up the principal part of their securities

activities.

At the end of 1986 the New York Banking Department, ignoring the old Glass-Steagallarguments that suggested the largest banks, if not severely restricted, could end upcontrolling industry, decided both J.P. Morgan and Bankers Trust New York couldunderwrite corporate equity and debt, commercial paper, municipal bonds and otheractivities formerly the sole province of the investment banker.

Q: I bet investment bankers loved that!

A: They claimed the states action would result in depressed underwriting profits for

everyone and that new investment banking talent would be that much harder to attract.

Q: And more expensive! Do you happen to know what is meant by the term universalbanking?

A: Universal banking is practiced in European countries, most conspicuously Germany,where banks are allowed to take unlimited equity positions in other companies. Japanesebanks are only allowed a five percent equity share. By contrast, American banks are notallowed to engage directly in non-banking activities because their deposits are insured bythe federal government and that would give bank-owned enterprises a distinct advantageover independently owned and operated entities. The market would eventually see to it

that all businesses in the country were owned by banks.

Q: It sounds like a choice between bank-controlled capitalism and stock-controlledcapitalism. It also seems like Treasury's plan to allow banks to affiliate with non-banksunder a common holding company is a taste of the former.

A:Not at all, because under the administration's plan, the affiliate would not be protectedby deposit insurance and fire walls would be erected.

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Q: In his Commonwealth speech, did Mr. Rosenberg specify other regulations that he feltwere especially anti-competitive?

A: He mentioned regulations that put a cap on the returns banks can make forshareholders and the limits on the kinds of products and services banks can offer

consumers. He suggested a repeal of the restrictions on interstate branching and reiteratedthe need for a recapitalization of the Bank Insurance Fund (BIF) within the FederalDeposit Insurance Corp. (FDIC).

Q: Did he volunteer how he might like to see the recapitalization come about?

A: Nothing really that we didn't already hit on in our discussion. He cautioned againstincreasing the premiums to such a degree that marginal banks would be unable to pay andhealthy banks might find their earnings too severely decreased.

Q: I believe the Bush administration is loathe to decrease the profitability of banks via

high insurance premiums and capital requirements. I've read elsewhere that for everydollar a bank pays in premiums to the FDIC, fifteen dollars are removed from its lendinginventory.

A: I think Mr. Rosenberg mentioned something like that also. He advocated a free marketin banking which would, he said, give consumers a wider choice of financial services andproducts at competitive prices than anything dreamed up by legislators.

Q:Not only that, there's safety in the diversity now prohibited by Glass-Steagall.

A: Absolutely. As we said earlier, there's safety in geographical as well as investment

diversity.

Q: According to Randall Pozdena, in an article for the Federal Reserve Bank of SanFrancisco Newsletter, there is a difference between the way leverage is viewed and used by private corporations and the banking industry. In a corporation, increased leverage(greater debt to equity) raises the expected return (earnings per share) to shareholderswhich makes those shares more valuable. On the other hand, reliance on debt weakensthe private firms ability to survive fluctuations in asset value without default andsubsequent bankruptcy.

A: Of course tax policy distorts the picture somewhat since interest payments on debt are

deductible against corporate income and dividend distributions whereas retained earningsare not.

Q: I've heard that most U.S. banks are already overcapitalized relative to the risks towhich they are exposed.

A: A bank has an incentive to either guarantee all of a loan or to retain the loan and therelated exposure. Therefore, while there may be far too much capital in the banking

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system as a whole, there may be far too little to protect the FDIC from experiencingcatastrophic losses in a severe nationwide recession. According to financial consultantLowell Bryan, having everyone raise more capital is not the answer. The problem lieswith specific institutions, not the entire industry.

Q: As you yourself have said, Congress has over and over again shown its propensity for blanket legislation rather than targeting needs. The problem is the commercial bankswould be risking depositors money. As legislators see it, the challenge is to restrain theenthusiasm of bankers and see that their greed is tempered with good judgment in orderto avoid results similar to those which came from their earlier plunges into real estate,energy and overly optimistic loans to lesser developed countries.

A: The third phase of the Depository Institutions Deregulation Act of 1980, looseningrestrictions on banks and savings and loans, was set to take place in 1984. However itwas overshadowed by a proposal from the Task Group on Regulation of FinancialServices which was headed by then Vice President George Bush.

Q: What proposal?

A: The plan announced in late January 1984 was to replace the comptroller's office with anewly created Federal Banking Agency within the Treasury Department. It would havehad jurisdiction over most of the then 1,425 federally chartered banks and their parents.

Q: What do you mean most? Are there some banks they wouldn't have controlled?

A: The fifty largest bank holding companies would have continued under the jurisdictionof the Fed which would have also acquired jurisdiction of the nine thousand state-

chartered banks then regulated by the Federal Deposit Insurance Corporation. The Fedcould have certified individual banks and release them to the jurisdiction of stateagencies.

Q: I never heard about this.

A: The gang on Capitol Hill kept it from seeing the light of day.

Q: Well,I'm grateful to those who blame deregulation for the massive savings and loanbailout and banking troubles that loom over taxpayers today. What do you think?

A: I'm always for as little regulation as possible and more decentralization of power. Butwhen institutions do a lousy job regulating themselves, government steps in. Regulatingis the easy part; everyone loves to tell everyone else how to act. The hard part isderegulation. A lot of people have a stake in maintaining federal and local regulation.Deregulation on the other hand, is like moving a mountain.

Q: John F. Kennedy gave deregulation a try when he was president.

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A: But it took the OPEC created inflation of the 1970s to give it any kind of momentum.In the seventies the airlines, trucking and finally financial institutions were deregulated.

Q: I thought Regulation Q was in effect all during the seventies.

A: Regulation Q was a prime example of unhealthy interference by government. If youremember, banks, under Regulation Q, were only permitted by law to pay five to five anda quarter percent to depositors when the prime [most favorable interest rate] was as highas twenty-one and a half percent! Inflation meant that savers were getting less real dollarsback than they put into the banks in the first place. Usury laws kept credit cards at elevenor twelve percent in some cases when borrowing elsewhere cost eighteen to twentypercent.

When deregulation overtook Regulation Q it was way overdue. Restrictive monetary policy had driven interest rates up and depositors had left banks for higher-yielding,unregulated money-market accounts.

Q: When was Regulation Q dismantled?

A: The interest rate ceilings imposed by Regulation Q were removed in 1982.Competitive banks immediately began paying depositors interest rates far in excess of therisk assumed.

Q:Risk assumed? With deposit insurance, there was no risk assumed.

A: That's the point. Government in effect subsidized those interest payments todepositors and allowed the banks to offer overly generous loans to borrowers.

Q: They could do that because technology had allowed them to raise deposits around theworld and they were unable to use those deposits for anything beyond the loan business.

A: That's right. The Glass-Steagall Act still keeps the big commercial banks fromunderwriting corporate securities in this country and competing with the investment bankers. If a transaction is successful the bank is often able to make money from themanagement fees and also from the profit on the deal itself. The difference between theadditional-fee-income and interest-income alone explains why investment banks enjoyedan average return on equity of twenty-six percent 1983-1985, while commercial bankshad to settle for an average return of fourteen percent. But these off-balance-sheet deals

stretch the banks capital in ways the traditional ratios fail to measure.

Q: No wonder they sought high returns through high-risk lending to Third Worldcountries and to commercial real estate developers.

A: You're right. The discipline of a free market was removed and speculators had a fieldday.

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Q: Most politicians tell it the other way: regulation was removed and speculators had afield day. They still haven't realized that government regulations cannot control marketforces. Government regulations just mess things up.

A: The trouble is, when one speaks of market forces in financial matters, one better be

prepared for booms, busts and their accompanying panics. The debate should not bewhether we rely on regulation or marketshistory shows unregulated financial marketsself-destruct. Problems arise when we try to use regulation to control market forces thatare beyond its control and in the process create flaws that skew the marketplace.

Barney Frank of Massachusetts is, in my opinion, one of the most brilliant men incongress. He showed that he knows darn well what is going on when he reminded fellowmembers of the banking committee that:

As you measure something you may be affecting it. As you regulate somethingyou may be affecting it. We ought not to pretend that the regulation is simply a

neutral look. Regulation is a calculation of risks. We under calculated the risks oflending and under calculated the damages of too little lendingwe need tobalance the two.

Q: It's only too bad that he has more faith in the ability of inexperienced legislators tocalculate risk than he does in experienced bankers and investors. He obviously prefersregulating to market forces. It seems to me that congress, instead of reforming the depositinsurance system, is simply increasing the power of regulators and examiners todetermine who gets credit and who doesn't.

A: You're right. When the losses from depressed real estate are tallied it is possible that

40 percent of all deposits will be in undercapitalized institutions. Therefore how thesedeposits will be lent will be controlled by regulators rather than management andshareholders. Naturally each participant will find ways to exploit the particular rules thatapply to him or her.

Strong banks will search for loopholes in Glass-Steagall and for states that will allowthem to do things not allowed by federal law. Non-bank financial firms will continue tosell bank-like products (money market mutual funds, credit cards, home equity loans)with a different set of rules. Instead of making market and economic and competitiveforces work better, this narrow reform will distort those forces. It won't be the quality ofservice that gains market share, but exploitation of rules.

Q: It has recently been suggested that instead of reviving Regulation Q with its inflexibleceiling on interest rates, that maximum interest rates on deposits be raised to the marketinterest rate on Treasuries. What do you think?

A: As long as legislators are determined to dictate to the market this proposal would atleast avoid the drain on banking that occurred under Regulation Q whenever the marketrose above the old inflexible mandated rates.

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Q: The average citizen has been pretty much brain-washed by media coverage andalmost to a man and woman believes deregulation has been the cause of most of ourproblems and must at least share the blame for the recent instability in the U.S. financialsystem. They honestly believe that deregulation encouraged banks to venture into riskyactivities that they often knew little or nothing about.

A: I grant you, the present trend is away from removing regulatory oppressions andtoward the imposition of new safeguards aimed at ensuring the safety and soundness ofthe banking system.

Q:Now who could be against ensuring the safety and soundness of the bankingsystem?

A: Exactly! Deregulation is a chicken or the egg question. Which is the cause and whichis the effect?

Q: For you maybebut as I've said, I think it is settled in the minds of most citizens andderegulation has been awarded the black hat!

A: Did you know that Islam forbids the payment of interest? They have a profit-or-losssystem where the borrower and lender make an agreement that delineates the way inwhich profits or losses are to be shared between the two parties.

Q: Sounds like an equity position where the lender becomes owner of the venture byagreeing to share in losses as well as profits.

A: That's an interesting way to look at it. I like the fact that risk is transferred to the

lender, which makes the lender more careful about the endeavors it finances. Thisemphasizes productive investments.

Q: That makes sense. I would expect lenders to become involved in a venture where theyhave placed money and to do their best to make it work. They essentially become teamplayers.

A: The banks' balance sheets would show equity positions on the balance side and theliability side would look like a listing of shares in a mutual fund. Instead of depositors,there would be shareholders and their returns would vary with the banks' returns. Therewould be no need for deposit insurance and no fear of runs on the bank.

Q: It is doubtful that the banks would have so easily lent money to LDCs if the return onthe investment depended on the success or failure of the project for which the money wasrequested.

A: Also if depositors viewed themselves as investors with money at risk, they wouldshop in order to put their dollars in the bank with the highest profit and least risk. Soundmanagement would be rewarded and encouraged.

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Q: And banks would be forced to find the most promising investments in order to attractdepositor-investors.

Hey, do you think we've hit on something? Do you think America's commercial banksshould forget about earning interest and become equity-based financial institutions?

A: I realize you're joking, but I really think a trend in that direction should beencouraged. An interim suggestion was tendered by Mohammed Alacem, associate professor of economics and Middle East editor of Economic Forum in an articlepublished in the May 9, 1991 Wall Street Journal:

Depositors could make standard deposits that are federally insured up to areasonable limit or could open an uninsured mutual fund account. Allowingfinancial institutions to play a dual role would give a much larger sector of theU.S. population access to mutual funds. The exposure of the (FDIC) woulddiminish as more depositors become more savvy and open accounts in the mutual-

funds side of the bank.

Q: That would stifle the entrepreneurial spirit.

A: What do you think tight credit does to the entrepreneurial spirit? Since marginal projects would not be easily financed, there would be fewer failures. A little cautionshould not be the death knell of the entrepreneur. It could help to ensure a greaterpercentage of successes, which ain't all that bad!

Q: A great theory but

A: Ok, I admit there are abuses.

Q: Sure, instead of making interest on a car loan, the Islamic bank purchases carsoutright and sells them to would-be-borrowers at a profit. If payments are made ininstallments, this is merely a disguised interest payment.

A: There are no perfect solutions but I think we should be looking for new and betterways to do things. I'm not advocating wholesale adoption, but we can pick and choosefrom a variety of ideas to upgrade our present system.

Q: I agree that we can't afford to be complacent when in FY1991 the FDIC paid out

$66.6 billion and is expected to disburse $100 billion or more in 1992.

A: Add on the seventy billion loan to the BIF (Bankers Insurance Fund) and there is aliability of two hundred and fifty billion in future outlays just to pay off depositors.

Q: That's what I mean. There are no constituents for this item in the budget. Everyonewould like to see it fall to zero.

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A: Falling real estate values will trigger more failures by thrifts, banks and insurancecompanies. Depressed real estate values lower the value of loans and securitiescollateralized by real estate which represent about thirty percent of bank, insurance andother financial institution portfolios.

Q:Not to mention that real estate makes up one third of household net worth andcontributes in varying degrees to the net worth of businesses.

A: Don't overlook the fact that commercial real estate is responsible for about twenty-three percent of all the taxes paid in this country.

Q: More than seventy percent of all local taxes collected.

A: That's right. Real estate values have an enormous impact on every community.

Q: Furthermore, as far as I can tell, every economic recovery in the post war period has

begun with real estate. This is serious stuff! How did we let this mess happen?

A: There's no one thing or person to blame, but it's fair to say the 1981 tax cut createdexcessive incentives which contributed to the overbuilding of commercial real estate.

Q: On the other hand, the 1986 act overshot and knocked the props out of real estateprices by taking risk capital out of the industry.

A: That's right. Then some people claim inadequate regulation was the cause of the over-aggressive lending which led to inflated prices and overcapacity.

Q: Enough with the problems and reasons. What's the cure?

A: We need to stabilize real estate values to prevent the failure of more institutions.

Q: How?

A: To get the industry moving again I believe we need a combination of lower interestrates, regulatory policies that allow sound real estate financing, and a federal tax programaimed at stabilizing and restoring commercial and residential real estate values.

The Fed has been attempting the first step by lowering interest rates but long term rates

need to come down further.

Secondly some of the lavish criticism that has been directed at both lenders andregulators needs to be curtailed. The constant blame has led to paralyzing fear. The Fedand regulators should assure lenders they will not be penalized by financing sound realestate investments.

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And hardest of all, because next year is an election year and partisan politics will be infull swing, congress should restore some form of passive loss treatment, cut the capitalgains tax and expand incentives for low-income housing.

Q: I'd advise some caution there. Existing commercial properties should be favored over

new constructionfor residential there should be incentives for new construction.

A: Stopping the decline of real estate would restore confidence and health to the capitalmarkets.

Q: The inevitable questioncost?

A: What such a program would cost in foregone taxes would be made up in fewer bailouts. Shortly after the passage of the 1991 FDIC reform act, Timothy Ryan, head of theRTC [Resolution Trust Corp.] told examiners not to write assets down to liquidationvalue.

Q: I bet that didn't sit well with Henry Gonzalez, chairman of the fifty-one memberHouse Banking Committee.

A: You're right about Mr. Gonzalez wanting to counter thisgo easy approach he felt wasbeing urged on bank examiners. After all, congress had just passed rigorous regulations,not geared to help Mr. Bush's re-election, so it is likely that Mr. Gonzalez thoughtmembers of congress were kept from the Baltimore meeting of bank examiners, whichtook place at the end of 1991, for partisan reasons.

Q: I've observed his banking committee in action and it is evident that Mr. Gonzalez

wants to see full disclosure of any banking industry problems. He believes the practice ofsweeping problems under the rug, is what led to the current Savings and Loan fiasco. Hehas gone on record as anticipating a banking crisis in the 1990s to mirror the Savings &Loan crisis of the 1980s.

A: That's right. He advocates early intervention and prompt takeovers. His zeal can, inmy opinion, be dangerous and lead to premature and unneeded bank closings.

Q: You've got to admit there were an inadequate number of regulators in the. RonaldReagan cut them back and went to off-site monitoring using computers and othertechnology.

A: Joel McLemore, was an FDIC examiner from 1976 to 1986. He wrote an article published in the Wall Street Journal on December 5, 1991. He revealed some of thetemptations, and often shady practices, of bank examiners on their way to the top of their profession. Bucking for a promotion led to some over zealous determinations. Hesuggested that most field offices have at least one hard-nosed examiner who put theburden to prove asset quality on the bank.

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These examiners enforce exacting standards that few banks can achieve. While oneexcessively ambitious examiner in ten might not sound like much of a problem, bear inmind that these examiners seek to do more examinations than others.

Q: When a few large, mostly adequately secured, real estate loans are classified as

substandard, even though risk of loss is minimal, the perception of the public andlegislators is skewed. Unfortunately individuals, companies, and in this case bankers,simply sit back and take itfrom their government. The feeling of powerlessness againstgovernment is becoming all too pervasive in today's society. That's why I like theprescription Mr. McLemore proposed for bankers.

A: What was that?

Q: He said:

Few banks bother to contest inaccurate [loan] classifications on the mistaken

assumption that such protests are futilea thoughtful proof that a classification wassubstantially incorrect will receive consideration. That proof might be sufficient to preclude some forms of corrective action, as agencies are sensitive to charges ofunfair practices.

A: I want to take a minute to relay an example of what is going on in this regard byreferring to an article by Daniel Clemente, a real estate consultant in Virginia, whichappeared in the November 4, 1991 issue of the Wall Street Journal. Mr. Clemente toldthe tale of a real estate development started in 1986 and aborted in 1990 after the first phase of 318 homes had been completed. Mr. Clemente was a consultant to the bankwhich acquired the uncompleted portion of the project in the spring of 1990. His firm

determined that to maximize the return on the sale of the land, it would be prudent tocomplete the engineering work. This would enable us to obtain final site plan approvalfor the subdivision of all land in phases two and three into building lots. . .because theapproval process is so lengthy, taking property to final approval adds great value to theproperty.

The bank was advised to complete construction of the sewer line but before this could beaccomplished the RTC took over the institution and decided not to go ahead with anywork on the described property. Consequently a year later the RTC (taxpayers) held 213acres of land with no access to sewer lines which will have to be marketed as acreagerather than lots.

In the meantime the preliminary plan approval granted by the town is about to expire.Since the original preliminary plan was approved, the town has altered its designstandards for public facilities. Engineering to meet the new design standards will cost anextra $440,600money that could have been saved had the RTC finished the job back in1990.

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Mr. Clemente went on to say that eleven neighboring property owners and the town itselfhad made agreements to shoulder some of the costs of the sewer system but the RTCdelay voided these agreements. Instead of costing $768,998 the sewer lines could nowcost $3.5 million!

Q: Well I imagine that will drag down the selling price of the property.

A: When foreclosed, the property was carrying $16 million worth of debt so you know itwas valued much higher than that. It is predicted to net the RTC somewhere between $3and $4 million. If it had been managed well and $1.5 million had been invested inengineering and review fees and sewer construction, Mr. Clemente suggests it could"reasonably be expected to yield in excess of $22 million."

Q: It's easy to see that if nothing is done; the downward spiral in the value of real estatewill accelerate, precipitating the collapse of commercial banks by undermining the valueof property held as collateral and eroding the principal element of every American

family's net worth: the equity in their home.

Real estate is a substantial portion of the nation's net worth and it has declined by aboutforty percent between 1989 and 1991.

A: It would be helpful if bank regulators stopped forcing banks to write down assets totheir artificially low present values when they have real long-term much higher value.

Q: There should be no need to value assets at bargain basement prices as long as theproperty is showing adequate return.

A: If bankers were left to make their own decisions, I agree with you that they might notneed to mark property to market as long as it was carrying the loan. Stocks, bonds, property and other fluctuating assets do not lose value unless they are sold. But mostlegislators know nothing about these things and value their own power above everythingelse.

Q: Does all the money Congress gives to the RTC go directly to depositors in institutionsthat have been closed?

A: The RTC doesn't use the money Congress gives it to pay back depositors, It uses themoney to purchase the bad assets of insolvent savings and loans.

Q: I've heard William Seidman say an asset looses twenty percent of its value the minutethe government takes possession.

A: That is the justification for providing subsides to those who purchase failedinstitutions and their undesirable assets.

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Q: I get it. The lesser subsidy saves the twenty percent that would be immediately lost ifthe RTC were forced to possess the bad assets instead of selling them with the institution.

A: Lamar Kelly, deputy in charge of asset disposition, said the RTC has sold more thanhalf of the assets seized in 1991 and in the first eleven months had raked in close to

eighty-one billion.

By the way, did you know there was a drafting error in the legislation authorizing theRTC?

Q: I suppose you'd fall over if I said, sure I knew it all along. Let's just say I'm notsurprised.

A: The original legislation in 1989 allowed the RTC to borrow working capital totalingmore than one and a half times its assets.

Q: You mean there is a perverse incentive to hold on to assets rather than sell them?

A: The more assets the RTC manages the more fees it is allowed to allocate, thanks to the1989 drafting error. Every time the RTC sell something, that sale reduces the amount ofworking capital the agency can borrow.

Q: How about putting a cap on the number of assets the RTC can have in conservatorshipand on its number of employees?

A: That has been suggested. It's always amazing to me how legislators consistentlyoverlook human nature when drafting laws. It is not shameful and it should be no secret

that people act in their own self interest. Why can't our legislators take this fact intoconsideration?

Q: I would imagine you would have something to say about the law which requiressavings and loans to deduct from their capital any direct investment in real estate.

A: What can I say? An amendment to grant temporary exceptions to this legislation andanother to decreased the amount of capital a S & L must hold for certain home-construction loans and for high-quality seasoned apartment loans, were deleted by theSenate, after passage by the House and before the final vote on the bail out bill inNovember 1991.

Q: And speaking of that bailout billI understand it was trimmed from the $80 millionrequested by the RTC to only twenty-five billion. Correct?

A: That's right. The bill was finally passed on a voice vote in the House and it was thelast vote to be recorded in the Senate, (44-33) after many members had left for the 1991holidays. Since the additional funds are only supposed to hold the RTC until April 1992,more legislation in this area is on the agenda.

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Q: Have you heard of bulk sales?

A: Sure. That refers to the practice by the RTC of selling several properties to one purchaser. In these transactions the government typically provides the financing andreceives a portion of the cash flow and the proceeds from any subsequent resale. At least

twenty-five percent of the real estate included in such deals is supposed to beunprofitable.

Q: I've heard the practice of combing unprofitable with profitable assets referred to asbundling.

A: That's what I'm talking about. These bundles are sold at a discount and saves the RTC,and ultimately the taxpayers, money. A quick sale is better than incurring the holdingcosts for managing the bad assets for a long period. In 1992 the RTC hopes to sell ahundred billion worth of assets with almost one-third bundled.

Q: But when you offer property for sale, all cash, at bargain basement prices, who do youexpect to attract as buyers?

A: I get your point. We're back to that old axiom I learned as a child, "Those who have,get."

Q: You're not kidding! Guess what happens frequently to those deposits we werediscussing earlier totaling more than a hundred thousand dollars?

A: I know what happens. These overly large, and therefore uninsured deposits, areprotected as a matter of policy if a bid has been received by the RTC that would be less

costly to the insurance fund than liquidation.

Q: In early 1987, Vernon Savings and Loan in Texas reported $1.35 billion in assets butabout $1.7 billion in liabilities. The trouble, according to a report of the Federal HomeLoan Bank Board, was imprudent and risky lending practices. Since losses are usuallydouble the amount of a failed institutions negative net worth, in Vernons case the losswas estimated at about $700 million.

A: In the summer of 1986 federal bank regulators decided to spend $130 million tosalvage the failing Bank of Oklahoma; only the eighth bank to be saved since 1933. FirstRepublic Bank of Dallas, which was formed in 1987 by a merger of Republic Bank and

Interfirst, in 1988 turned to the federal government for relief. Reportedly sixteen percentof its loan portfolio was bad, leaving bond holders and shareholders at risk.

Q: I remember in 1988, First Republic was the same size as Continental Illinois was atthe time of its rescue by the federal government in 1984. But I'm confused. I thought theFDIC only protects the bank's depositors.

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A: That's generally true but FDIC protection didnt stop depositors from withdrawing sixhundred million from the bank in the first quarter of 1988.

We enter the dialogue to hear a discussion of the problems associated with governmentregulation and bank failures.

Q: Didn't Professor George Kaufman of Loyola University in Chicago come up with a plan calling for quick closure of troubled banks while there are still resources to paydepositors and creditors when the banks net worth is zero rather than sub-zero?

A: Timely closure would allow more equal treatment of banks regardless of their size,location or nature of their business.

Q: Does that mean no bank would be too large to fail?

A: It may have meant all banks, large or small, should have help to survive. I see the

challenge as not to eliminate bank runs, but to harness consumer power in such a waythat the financial system will be both safer and more efficient.

Q: First National Bank & Trust Co., Oklahoma City; M Corp of Dallas and FirstRepublic, Texas and Bank of New England were all considered too-big-to-fail. Their sizemade it highly unlikely that they would be purchased and absorbed by other banks.

A: Well keep in mind that it cost less than a billion dollars or about 3.5 percent of theFDIC's total insurance losses during a five year period to protect the deposits thatexceeded the $100,000 insurance limit in those institutions.

Q: Economists fear that a large bank failure could result in adverse macroeconomicconsequences and instability in the financial system.

A: Don't get over dramatic. After all about ninety percent of small-bank failures areresolved through P&A, purchase and assumption transactions. In a P&A, all the depositsare assumed by a healthy take-over bank. Of the 169 banks that failed in 1990, onlytwenty were resolved through a payout of insured deposits. Naturally a P&A is less costlyto the FDIC than liquidation.

Q: Are you saying it is impossible for large depositors to lose now days?

A: That's not what I am saying. The National Bank of Washington (NBW) failed inAugust 1990 and all depositors were protected, but when the minority-owned FreedomNational Bank folded, depositors with accounts exceeding the $100,000 FDIC protectionlimit were losers.

Q: That sounds suspicious to me. It sounds like the depositors in NBW had clout. Whowere the depositors at Freedom Bank?

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A: There were people with clout. Included were the United Negro College Fund, the National Urban League, many churches and the campaign committee of DemocraticCongressman Charles Rangel. But it wasn't a matter of clout. NBW had deposits of $1.1billion and was too-big-to-fail whereas the deposits of Freedom National totaled only $91million so regulators apparently figured its liquidation wouldn't damage the banking

system or the nation's economy.

Q: So Freedom's big depositors lost out?

A: I said the decision not to pay the large insured accounts was not based on clout but Ididn't say clout didn't play a part in the outcome at Freedom Bank. The New Yorkcongressional delegation pressured the FDIC so at the end of 1990 it announced that itwould pay off about half of the fifteen million in Freedom National's uninsured depositclaims.

Q: Let's cut to the chase. The concern is that the federal government, meaning taxpayers,

may end up bailing out all the banks.

A: Absolutely. You can bet there will be more banks as well as savings and loan bail outsin the future and the FDICFederal Deposit Insurance Corporationmay not be able toafford to pay off all the insured accounts.

Q: So here we are at the end of 1991. Legislation was actually passed in Novemberwhich included strict capitalization requirements and higher fees to finance the seventybillion replenishment of the FDIC. [The FDIC Improvement Act of 1991.]

We got an FDIC bailout measure without the hoped for banking reforms which would

make banks more profitable and competitive. Proposals to allow

Taking a Stand on Banking

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